Thread by @0xfoobar

why vAMMs are doomed to fail 🧵

first, what's a vAMM?

a virtual automated market maker is like a uniswap v2 pool without any actual liquidity. it simulates having liquidity, and moves prices up and down with buys and sells like it was xy=k

but there are no underlying tokens, just math simulations

why is this an attractive product?

because it gets you levered perp-like behavior on arbitrary tokens, like NFTs. this makes bootstrapping markets easier. and users love it, as shown by 500MM of volume on the nftperp beta

so what's the problem?

problem is there's no actual money in the system. so what happens if everybody longs, nobody shorts, and price goes up? who can exit and how?

the easy answer is "funding rates". but who pays the funding rates?

in an orderbook system, longs pay shorts when perp price is above oracle price, and vice versa. this is possible because orderbook matching guarantees an *equal size* of longs and shorts

vAMMs have no such guarantee

in fact, there's almost guaranteed to be an *imbalance* of longs and shorts, because the xy=k model means that price can only move from its starting point when there are more buyers than sellers, or vice versa

and true prices change all the time

so over the long run 1 of 2 conditions must be true:

- longs and shorts are mismatched
- perp price doesn't track oracle price

in practice no platform can be taken seriously if the second condition doesn't hold, so we see the first

note that if BAYC started at 10 ETH then went to 30 ETH, there must be more longs than shorts. this is true even if perp price tracks oracle price, because of xy=k

so longs need to be paid funding. where does the funding come from? it can't come wholly from shorts, because there are more longs than shorts. so the platform must pay out funding rates from its treasury fees. this is true no matter whether we have an excess of longs or shorts

and so vAMMs are this tricky balancing act of hoping that platform fees outpace platform funding rates, forever. this eventually fails.

and what happens when it fails? people try to exit

now remember, there's no actual liquidity in a vAMM. so how can people exit?

the amount of profit they're entitled to is determined by the xy=k curve, and the only actual money in the system comes from other users' collateral

in an orderbook model, one user's profit is another user's loss. so you can credit profits and losses against each other. but this isn't true for vAMMs! it's possible for everybody to be in profit at once, if they all longed the same coin and it went up

so the first people to sell on xy=k dump the perp price below what oracle price is, funding rates spike, platform treasury gets crunched to pay the elevated funding rates, more people exit, more price dislocation, more funding rate payouts, platform goes bankrupt

while obviously this is a juicy target for manipulation, it can also happen from organic price movement. say a vAMM spins up when ETHUSD is $10. then ETHUSD goes to $10k over the course of a decade. the only way xy=k perp price can track spot price is with long-short imbalance

we saw a test run of this in the opposite direction when LUNA went to 0 last year. as people rushed to arb perp vs spot on vAMMs like Drift v1, there was massive short-long imbalance. funding rates went crazy, platform couldn't pay ot users, race to get out, everything collapsed

TLDR - you can't internalize potentially toxic orderflow on arbitrary perps, especially low-float assets that can be cornered through either individual or emergent activity. the vAMM failure case is a specific instantiation in a larger hopeless design space